Change Is Coming At PepsiCo, One Way Or Another

It is interesting how Wall Street will seem to reward companies that are, in many respects, underperformers. One such example is the relative valuation between Coca-Cola (NYSE:KO) and PepsiCo (NYSE:PEP). Relative to the possible future cash flow streams, the companies seem roughly equally valued, even though Coca-Cola is in most relevant respects the superior operator. What that tells me is that the Street already assumes that PepsiCo's restructuring efforts will either succeed or that the company will take more dramatic steps, including a potential break-up.

Mixed Numbers for the Second QuarterPepsiCo is surprisingly well-liked within the analyst community, and it's interesting to see how much they celebrated what looked like only a so-so earnings performance. While these results were better than expected, expectations were pretty modest.

Revenue fell about 2% as reported, with organic growth of 5% made up of 1% volume improvement and 4% pricing increases. The Americas businesses were mixed, with foods up 3% as reported and 7% organic due to strong performance in the Latin American business, while the beverage business was up just 1% (2% organic) as the company logged weaker volume than Coke. Europe was up more than 3%, with organic growth in the Asian region up about 10%.

Margins were also pretty mediocre. Gross margin dropped about half a point, while reported operating income fell about 5%. Once again, the "Americas" (PepsiCo American Foods and PepsiCo American Beverages) were weaker - down 2 and 4%, respectively - while the overseas businesses showed profit growth.

Get Better or Break-UpPepsiCo is about one-third of the way into a more concerted effort to restructure its operations, including promotion activities. On the beverages side, the company is looking to match Coca-Cola with more packaging options, but part of the problem is the word "match" - PepsiCo is still in a position of reacting/responding to whatever Coca-Cola does.

On the international side, there's still room for improvement. Results have been hampered by both market-building spending in countries like China and misdirected spending into less-promising markets like Eastern Europe.

It will be interesting to see what happens in a year or so if/when these efforts haven't moved the needle much. I would not be surprised to see significant pressure on the company to break up its operations, letting the very successful snack foods unit operate independently of the more troubled beverages operations.

Still Plenty of Room to Grow and InnovateOne of the encouraging facts of life for PepsiCo is that there's still a lot that can be done in its core addressable markets. Companies like Kraft (Nasdaq:KFT) and Kellogg (NYSE:K) are pushing aggressively into snacks, but this competition could also benefit PepsiCo - the recent bankruptcy of Hostess suggests that there could be more struggling brands that a larger player could scoop up.

Likewise, there are opportunities in beverages. Pepsi's Gatorade business is arguably underappreciated by investors on its own merits, and companies like Nestle (OTC:NSRGY) are really focusing on developing and promoting "functional foods" with performance or nutrition claims. There are also opportunities in areas like flavors and sweeteners, where both PepsiCo and Coca-Cola are in an arms race to find better ways to give customers their sweet fix without the calories.

The Bottom LineAs I said in the intro, I find it curious that the Street is already giving PepsiCo a lot of credit for the improvements that are supposed to be coming. Again, some of this could be packed up by the assumption that PepsiCo will either improve or break-up, and at least in theory those should unlock some value and growth potential.

Nevertheless, while this is a popular stock with the sell-side crowd, I'm not joining in the excitement. The company's 5% organic growth this quarter was encouraging, but even a forward free cash flow growth assumption of 8% doesn't support today's valuation, let alone give room for a meaningful upside. That said, from a more technical standpoint, with the support this stock enjoys, I can see the shares going higher so long as management is seen to be executing on its self-improvement goals.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.